Passionate readers of this site and fellow DIY investors in Canada will know both of us here at Cashflows & Portfolios (along with many site subscribers and members as well!), have some form of plan to “live off dividends” during some semi-retirement or retirement years.
However, we wanted to explore this question: is living off dividends a mistake?
Read on for some thoughts and risks related to this approach!
The downside of dividend investing in general
For some investors, not all mind you, they seek out purchasing shares of companies that pay dividends to shareholders. As such, when owning a dividend-paying stock, when an investor buys a company that tends to pay a regular and/or increasing dividend, said investor receives a portion of the organization’s profits more readily versus the expectation of capital gains. Thus, this method of investing can provide 1) more tangible near-term income to the investor in the form of a dividend payment while 2) providing some level of confidence to the investor their portfolio value should also grow over time.
My Own Advisor has used this graphic many times before on his site – which nicely illustrates just one of the tradeoffs that come with investing in dividend-paying stocks, or only dividend-paying stocks if that is your decision:
Investing with a dividend focus allows an investor to take advantage of many aspects of investing (i.e., buy and hold) while separating themselves from volatile stock market prices – they can focus on the income they receive from the companies they own, reinvest that money, or spend that money as they, please. In doing so, with this “optionality” in mind they can be less emotionally bothered by any ebbs and flows in the company’s stock price over time.
That’s good news for many dividend investors…
Of course, the downside to all of this dividend focus is that you could be missing out on literally a world of stocks that do not pay any dividends but do other things to increase shareholder value over time. Shareholder value can be created in many ways. Ideally, every management team in every company will allocate profits in a manner that optimizes shareholder value time and time again.
We all want that – value for our investment – regardless of dividends – right??
In our mind, here are just some things that can increase shareholder value in no particular order:
1. Make profits! Many growing companies are not yet profitable or at least take some time to generate a profit. Profitable companies trade at higher prices than companies that are still losing money – which makes profitable companies desirable to own. Paying a dividend to shareholders would potentially rob a company of the alternative to reinvest profits back into the company for meaningful growth. Read on.
2. Increase earnings per share. Akin to point #1, profitable companies that increase their earnings per share (EPS) generally increase shareholder value since stock prices can rise when performance shines – so a company that consistently increases its per-share earnings is consistently increasing shareholder value. Watch for that metric when researching any companies to own = rising EPS over time.
3. Increase free cash flow. Growth-oriented companies often generate negative free cash flows (FCFs) but we like companies that make plenty of cash – so they can pursue new opportunities, such as new acquisitions, grow more products, develop new services, and buy back shares. Shareholder value is created with higher FCF.
4. Companies can also repurchase shares. Building on point #3, a company that repurchases its own stock can also increase shareholder value because share buybacks usually have a beneficial effect on the company’s stock price. With fewer outstanding shares in circulation, that can indirectly boost shareholder value by increasing per-share earnings.
And on, and on, and on…
At the end of the day, stock prices rise based on many factors, and certainly, dividends are not the reason.
And just to drive another point home: common stocks are never required to pay a dividend. I mean, at the Board of Directors’ decision whims, any company can pause or cut its dividend payment at any time.
The downside to dividend investing in general is that any company, at any time, could make a decision to make better use of its profits (instead of paying a dividend to shareholders). Any investor with strictly a dividend focus needs to understand that.
The upside of dividend investing – for retirement planning
Now that we’re on the same page when it comes to the “optionality” of dividends, let’s look at some of the upsides before we get into some quick numbers and brief examples below.
It’s no secret that both of us at Cashflows & Portfolios own many dividend-paying stocks in Canada for income and capital gains but it’s also important to understand that’s simply how most Canadian, top-market capitalized companies return value to their shareholders.
For years, as in almost decades now, we’ve both looked at low-cost, broad market ETFs in Canada like XIU (iShares S&P/TSX 60 Index ETF) as a proxy for some companies to own individually in our portfolios. We both figure if the top 60 companies in Canada are not making money/profits, well, it’s going to be a struggle for anyone else!
Using XIU as our key example for skimming that index for companies to consider owning, we know that the TSX 60 index owns typically large, established Canadian companies that have a history of making profits, increasing earnings per share, increasing free cash flow, and from time to time, making acquisitions too. Many companies in that list also happen to pay a dividend and better still a growing dividend, so we own them!
We when speak of buying and holding our dividend-paying stocks in Canada, it’s really not enough to reward shareholders like us with just a dividend payment. We are also seeking price gains too. Total returns matter.
Therefore, the upside of dividend investing – for retirement planning in Canada at least is the reality that some of the most profitable stocks in Canada also pay a dividend. We believe this is helpful context in such publications or graphics below.
“Dividend-paying companies represent a significant portion of the Canadian equity market and are typically well-established, soundly managed companies with stable businesses. Dividends can also be an important part of a portfolio’s total return, helping to offset losses in times of market declines, while boosting portfolio returns when markets are rising.”
Updated Source: https://www.rbcgam.com/en/ca/learn-plan/investment-basics/the-power-of-dividends/detail
“Over the past 46 years, dividends have contributed an average of 3.2% per year to the S&P/TSX Composite Total Return Index, representing approximately thirty percent of the average annual total return.
While no one knows exactly when markets will move up or down, dividend income can help deliver consistent cash flow to investors. It can also provide exposure to the compelling growth opportunities that are emerging amid solid corporate earnings and improving global economic growth. Dividend-paying equities can also offer a yield premium over Canadian government bonds and may offer more favourable tax treatment.”
Is Living Off Dividends a Mistake?
To answer this question, we wanted to run some simple projections.
Certainly, before we get to that, we must say that many clients that visit our site, that are members of our services, believe in total returns from their portfolios to support maximizing retirement spending and fun. Good on them to do so!
Many clients we know have been widely successful as DIY investors by investing in not only Canadian stocks (stocks that pay some dividends) but also in a world of stocks beyond Canadian borders too – for decades on end. Their success can be largely attributed to a disciplined savings rate, keeping their investment costs low, and sticking to a plan they believe in.
While every DIY investor, including our members, invests differently we see many themes from them beyond those good behavioural traits above:
- They have devised their own portfolios based on their investment risk tolerance, their desired mix of stocks, fixed-income, or cash that helps them meet their personal finance goals and objectives – and nobody else.
- They tend to be conservative over the years with their expected returns (the sum of dividends paid and/or capital gains delivered) such that they have saved like pessimists over a few decades while being optimistic about their financial future.
- Most treat dividend income as just one form of income from their portfolios since most expect to sell assets from time to time (assets that have delivered significant capital gains) too.
This latter part gets to the heart of our post and examples today.
Depending on your spending needs in semi-retirement or retirement, you will need a sizeable portfolio to just “live off dividends”. While your math will vary from someone else’s income needs, and your math will also vary depending on whether your retirement savings/investments were mostly in taxable or reside in tax-sheltered accounts (i.e., RRSPs, TFSAs), let’s just say that you’ll likely need a million-dollar portfolio to even attempt this beyond any future government benefits like CPP and OAS.
For example, at the time of this post, the aforementioned S&P/TSX 60 which again represents the 60 largest and most liquid stocks on the S&P/TSX Composite index tends to yield ~ 3% in dividends or ETF distributions via XIU rather consistently.
Capital gains are delivered beyond that.
So, dividends can provide a head start to deliver meaningful retirement income but you should not ignore price appreciation. If you are too conservative with your withdrawal rate, for too long, coupled with modest to lower spending needs, then even with modest inflation fighting your portfolio you could be missing out on spending much more during retirement.
Certainly, if you own some of those XIU-listed Canadian stocks directly like many DIY investors do, such as Canadian banks, pipelines, and telco companies, it would not be surprising at all to see your yield delivering between 4-5% per year, every year.
As an investor, if you simply focused on living off your dividends or distributions, throughout retirement, we believe while you may realize your desired retirement income spending needs you’ll find over time that you’ll incur at least one or more other financial problems:
- Higher taxation.
- Too much estate value.
As far as we know, nobody likes paying more tax than they need to. While paying some tax at a point in time is a “good problem to have” (i.e., it means you have a high income in your working years or in retirement years) sustained, high taxation is not tax-savvy and should also be reserved for only the very wealthy. Even then, the very wealthy try and mitigate taxation!
Unless you want to create generational wealth, and some folks might, by only living off your dividends or distributions over decades you are very likely to grow that initial million-dollar portfolio into something much larger even with spending during retirement. Keep in mind in your financial future there could be the notion of downsizing your home, decreasing some spending after your go-go retirement years, and/or there could be some inheritance that could be transferred to you as you age.
Simply put, ignoring capital gains and spending just the dividends and distributions from your portfolio throughout retirement should be done at your high taxation or high estate value peril. We have some simple examples below to illustrate that.
In example #1 we profiled a 55-year-old investor who has saved very well over the decades. They have amassed a million-dollar portfolio. We don’t like they love the 4% withdrawal rule (link at end!) but so be it – they are using that rule of thumb and their dividend income to deliver $40,000 per year in the first year of retirement and then going higher over time.
Here are the other assumptions/inputs for this investor:
- Want to spend $40k per year, starting age 55, in Ontario.
- Assumed 60% max CPP, taking CPP at age 70.
- Assumed average OAS at age 65.
- No other income in retirement.
- $0 RRSP value, they didn’t believe in this account and wanted to earn tax-efficient dividends only!
- $1M non-registered assets, just in Canadian dividend-paying stocks as their bias.
- $0 TFSAs although they may move some non-registered stocks into their TFSAs in the coming years.
- We have assumed 5.0% rate of return, mostly dividend income.
- Longevity age 95.
- Spending increases by 3% sustained inflation.
For this 55-year-old:
With conservative spending in retirement and a focus on spending dividends only, the portfolio value will be maintained until CPP starts at age 70. At this point, due to CPP offsetting cash flow needed from the portfolio, along with OAS turned on at age 65, their net worth will actually start to increase! In this scenario, at age 95, they will end up with a final estate of $1.17M after-tax!
In example #2 we profiled a 65-year-old investor who has also saved very well over the decades. They too, have amassed a million-dollar portfolio, and as a close friend to the 55-year-old investor above, they also love the 4% rule.
Here are the other assumptions/inputs for this 65-year-old investor:
- Want to spend $40k per year, starting at age 65, also in Ontario.
- Assumed 80% max CPP, taking CPP at age 70 – they worked full-time a bit longer.
- Assumed average OAS at age 65.
- No other income in retirement.
- $0 RRSP value, just like his younger friend, he didn’t believe in this account and wanted to earn tax-efficient dividends only!
- $1M non-registered assets, just in Canadian dividend-paying stocks with the same bias.
- $0 TFSAs, just like his friend.
- We have assumed a 5.0% rate of return, mostly dividend income but with some slight capital appreciation like his friend.
- Longevity age 95.
- Spending increases by 3% sustained inflation as well.
For this 65-year-old:
Again, with conservative spending in retirement and a focus on spending dividends only, the portfolio value will continue to grow throughout retirement! Due to CPP and OAS offsetting the cash flow needed from the portfolio, their net worth will continue to increase throughout retirement! In this scenario, at age 95, they will end up with a final estate of $1.86M after-tax!
Sure, the 65-year-old is older than the 55-year-old. They have more CPP income too. Yet the point being, in both basic examples assuming 5.0% rates of return, from 100% equities, from Canadian dividend-paying stocks over the coming decades with modest, sustained inflation at 3%, both investors will see financial assets grow, estate values will grow and average tax payments slowly rise over time if they stick to live off dividends approach – being conservative with their returns and related withdrawals – potentially leaving tremendous wealth on the table.
Is Living Off Dividends a Mistake?
We cannot leave this post without talking briefly about inflation a bit more.
Inflation is a legitimate concern for many investors these days and it has the potential to threaten many retirement plans. We believe however inflation will subside eventually and normalize over the coming years – but let’s also remember that some stocks, certainly in some sectors, can be an inflation hedge and should increase in value/deliver those capital gains over time. If you plan to live off your dividends exclusively throughout retirement, you may grow your capital during retirement and you can utilize any capital gains at your leisure to fight some inflation.
The wealth-building path to owning a million-dollar portfolio doesn’t have any secrets. You need to have a high, sustained savings rate and you need to largely invest in equities/common stocks over many years to do so. Time and compounding will do the rest for you. Everyone can build a diversified retirement nest egg. How much that nest egg becomes depends a bit on you and your behaviour.
How you want to spend that nest egg during retirement is also a very personal decision. Some folks want to live off dividends for a few years and others will take a more total return approach and start selling off assets, slowly, over time right out of the gate. Either way can work.
We do believe at Cashflows & Portfolios unless you want a sustained tax bill and/or a large estate for someone else to enjoy after you are gone, solely living off dividends or distributions with sustained conservatism is likely a mistake. You are likely to leave a good deal of wealth on the financial table that you or others could have otherwise enjoyed while you are alive.
Need any support with your retirement income projections?
Knowing how to save and invest wisely, whether that’s owning a low-cost ETF like XIU in Canada or others beyond Canada growth – is just one important part of the investment puzzle. In addition to that asset accumulation work, we believe you need to understand asset decumulation too – how to enjoy the money you’ve worked so hard to build in a tax-smart way as you manage your retirement portfolio.
Figuring out when to considering drawing down your RRSP/RRIF assets, by how much, and when amongst other assets and accounts like TFSAs, your pension; when to take CPP or OAS and more is complex work.
We can help.
We deliver personal reports to help you make decisions and navigate your retirement income drawdown plans – it’s something we’ve helped dozens upon dozens of clients within the last few months alone!
If you are interested in obtaining private projections for your financial scenario, read more about our retirement projections service.
Further Reading and Insights:
Some Canadians expect to need $1.7 million to retire with – that’s a major problem!
Thanks for your readership!
Mark and Joe.